Intertemporal speculation, shortages and the political economy of price reform

Tilburg University

Intertemporal speculation, shortages and the political economy of price reform

van Wijnbergen, S.

Publication date:

1993

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van Wijnbergen, S. (1993). Intertemporal speculation, shortages and the political economy of price reform.

(Reprint Series). CentER for Economic Research.

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~ ~IïJI"n(II II`I II

I~I~~I~II IIIII II~II~ ~III~I~I ~I~II ~~I~I II~II ~~~I I~~I

Intertemporal Speculation,

Shortages and the Political

Economy of Price Reforrn

by

Sweder van Wijnbergen

Reprinted from The Economic Journal,

Vol. 102, No. 415, 1992

~ ~~

_{Repri nt Series}

CENTER FOR ECONOMIC RESEARCH

Board

Harry Barkema Helmut Bester

Eric van Damme, chairman Frank van der Duyn Schouten Jeffrey James

Management

Eric van Damme (graduate education) Arie Kapteyn (scientific director)

Marie-Louise Kemperman ( administration) Scientitic Council

Anton Barten Eduard Bomhoff Willem Buiter Jacques Drèze Theo van de Klundert Simon KuiPers Jean-Jacques Laffont Merton Miller Stephen Nickell Pieter Ruys Jacques Sijben

Université Catholique de Louvain Erasmus University Rotterdam Yale University

Université Catholique de Louvain Tilburg University

Groningen University

Université des Sciences Sociales de Toulouse University of Chicago University of Oxford Tilburg University Tilburg University Residential Fellows Lans Bovenberg Werner Guth Anna-Maria Lusardi Jan Magnus Theodore To Karl W~rneryd Research Coordinators

Eric van Damme

Frank van der Duyn Schouten Harry Huizinga

Arie Kapteyn

CentER, Erasmus University Rotterdam University of Frankfurt

Princeton University

CentER, LSE

University of Pittsburgh

Stockholm School of Economics

Address : Warandelaan 2, P.O. Boz 90153, 5000 LE Tilburg, The Netherlands

Q~i'i c

~Q~~Í~

for

Economic Research

Intertemporal Speculation,

Shortages and the Political

Economy of Price Reform

by

Sweder van Wijnbergen

Reprinted from The Economic Journal,

Vol. 102, No. 415, 1992

Thr F.enrtanrr Jneernal, to2 ~:Vae~rnebo rr~r~ti, r~ir~,, r.to~i Pnnled in Grrn! Bn[nm

I~TERTE~IPORAL SPECULATI0~1,

SHORT:`GES A~D THE POLITICr~L EC0~10~IY

OF PRICE REFOR~~I~`

,Sr.ueder uan 66'ijnber~rn

Hvw should prices be decuntrolled, slvwly or in a bi,g bang? Whv is it that Governments committed tv eventual price flexibility so often seem to be unable to let go of `temporary' contrvls? How can one explain that after price increases early in a proqrammc of price controls, output often rises while at the same time shortages also increase (Bresser, sg87?? This paper argues that intertemporal speculation, hoardin,g and the pvlitícal economy of price reform go a long way towards explainin.g all these puzzles. ~Ve show that the interaction between shortages and pvlitical vulnerabilitv of reformist s;overn-ments to early perceptivns of failure make lór a strong ar,gument Rgainst gradualism in the decvntrol of prices.

Price controls are often used as substitutes for, rather than complements of, regular fiscal and monetary restraint; thev thus ended up suppressing rather than curing infiation. More recently they have scen more sophisticated use, as transitional devices in stabilisation programmes that also encvmpassed orthodox components ~Mexico and Israel are successful examples).

The literature on price controls has focused on their potential macro-economic rationale (Dornbusch and Simonsen, tg87; Persson and van 1Nijnbergen, 1 g8g}. This paper abstracts from the question of why price controls are used. Instead it asks a difíerent question, one that is perhaps of greater practical importance: how to escape from a period of controls? The issue is of much wider importance than the stabilisation policy examples suggest; all of Eastern Europe has been living under price controls, imposed for a verv difïerent reason. How should countries like Poland or the ex-L' SSR move towards price Hexibility, gradually or in a`big bang'?

Two factors complicate the issue. Often price controls focus on commodities that are storal~le and thus can be used in intertemporal speculation. This was acute in Braail, where in tg8~ price controls were introduced which were verv much seen as temporary. Bresser (tg87), who was the finance minister at the time, states: `There was shortage of inerchandise in stores at the [same] time that stocks were accummulating in the factories'.

The second factor is that opposition to rapid dismantling of controls is often based on claims of low supply~ response, and greatly bolstered if a strong

supply-' Fnr claboration on some of the more technical details of this paper tha readcr is referred to the workinq paper senion ican Wijnbergcn, tggt i, s.hich is as~ailable on request from the author. I am indebted to `tax Corden, Ales Cukierman, .~ntonio Estachq Arye Hillman, Santiago Lecs, Dani Rodrik, Lars Svensson and seminar participants at the ~Vorld Bank, the IMF, Princcton, Pennsyhania State and the wharton School for helpful comments. The ciews esprcssed in this paper do not necessaril~. coíncide with those of the institutions I am affiliated with.

1396 _{THE ECONOMIC JOURAAL ~NOVEMBER} response indeed fails to materialise. This is especiall~~ relevant in places like Eastern Europe, where experience with price responsive markets is limited. A less benign argument also lends support to a link bet„'een low supply response and opposition to relaxing controls. Shortages create rents, and rents will attract lobbyists in favour of continuation of those policies that create the rents.

We show the difficulties that these two factors create for gradual decontrol of prices. We endogenise the probability of a collapse of the reform programme along the lines of the recent literature about the impact of political considerations on economic policy (see in particular Alesina and Cukierman ( t ggo) ) and show that such endogeneity in thé presence of intertemporal speculation leads to a strong case against gradualism.

I. SPECULATION AND SUPPLI' RESPONSE TO GRADUAL

PRICE DECONTROL

I. t. The Basic Model

The traded sector uses labour only, and at constant returns to scale; thus the real wage w is fixed in terms of traded goods. Returns to scale are decreasing in the non-traded sector, because of a fixed factor in the background (land). There are many producers, s0 individual producers cannot affect the price, or, in the case ofcontrols, aggregate shortages. Non-traded output toda}~ equals I', and output tomorrow y. The cost function far current (future) non-traded

production equals C' (c) :

i7) Capital ( lower casej letters represent first {second~ period variables.

Output produced todav can be sold toda~. or stored for sale tomorro~ti-. Since there are only two periods, output produced tomorrow will be full~. sold. CToods stored toda~., S', lead to goods available from stora,,e in period ~ according to the technolog}. ~:

S- rr~(S) i ~(O) - O, O G~i' C I, ~!" G O. (~)

Part Of goods stored goes t0 waste due to spoilage, pests and so on. Thus there are positive marginal costs of storage (yi' e t j. ~~'e also assume that the marginal costs increase with the amount stored ~~" c o).

The market clearing price in period t f2) is P~` 'p~`1. Controls are imposed in the non-traded sector only. Beforr the announcement of decontrol, prices were set at P, - p„ C P~`,~i~`, G'old turlcey drennlrol implies immcdiate transition to market prices in both periads. Cradual deconlrol implies a pricc- increasr in lieriud t that falls short of;oing to market prices: P~ e P~` ; whilc a full move tu markc~t prices is announced for period two.

Call p the probability that the decontrol program will be abandoned. 11'e assumc that when the programme of gradual decontrol is abandoned in pcriod ~., the controls will be kept at their levrl of pcrir~d t, i.e. in that ca;e ~~9 - 1'p. A

Igg2~ POLIT[(:AL ECONO~il' OF PRICE REFORM t397 collapse ol thc c.old turkcy clecontrol programme does not have such an ohvious delàult position; we assume that if the cold turkey programme collapses, prices in period two will he sct at thc pre-decontrol Ievel P~. Both producers and consumers takc P as uivcn.

Producers ha~e to choose today's output and level of inventories before knowing whethcr the C,vvernment will implement its announcements for period two or whether the programme will coliapse halfway. However second period output can be chosen after period 1 Government policies have become clear. The second perioci pmduction decision is thus a simple static optimisation

problem:

Nocollapse: ~Iax(p~`[y~`f~(,S)]-c(w,y~`)iyCy(y~`) -p~`,

Colla Se: ~Iax;P_{P~ ~(y~}-F-_4~(,5'_{) ]-}clw_,y~)f'-yc !_{„ y~}) -P._,

(3)

[n general p9 ~ p~. ~1~'e will however omit the subscript.

In period one producers have to choose output Y and the part of output put in storage. S, knowing that in period two thev will follow the rules laid out in

(3). This leads to the following masimisation problem:

íV1ax ( Y-S1 Pp-C'(w, Y) fa',P{(y~-~(.S)]p-c(w,yj} subject to o~.S c Y

,~, s

(4) rs - t ~( t f r) with r the exogenous world real interest rate in terms of traded

goods. ~r7 is the expectations operator. The first order conditions are:

CY-Po~~' ~

-P9fS~'~up-~.l-fc - o. ~ (~)

.l(~e) is the shadow price associated with tkie constraint S 1 o(S e Y). (~) indicates that output will be increased until its marginal cost equals the value of an extra unit of output. This latter value equals the price plus any additional shadow price picked up by im-entories if they are constrained by the fact that additions to inventories cannot exceed total production.

Inventories are chosen so as to equalise the value of an extra unit of output today ( P~) with the discounted value of an ertra unit tomorrow (drr5'rB9 pl. Of course if inventories hit a corner solution ( o or Y), that equality cannot be brought about and either.t or,te becomes positive, driving a wedge bet~veen the marginal benefit of an extra sale today versus an extra sale tomorrow. Clearly, higher prices lead to higher output in each period:

~

dP - C:.

~ o, p~ - cYy(y~`) ~ o~ dPo - cYV (y~) ~ o.

(6)

The analysis for `cold turkev' decontrol follows along similar lines.

1398

E- E[n (P'~ t), an(p~`, t), Cr]- (7)

The derivatives of E with respect to prices yield tlie Hicksian demand functions. 17 and n are exact price indices for current and future consumption corresponding to the utility structure underlying ( ~). However, when price controls are binding, consumer demand is not met at quoted prices. Define

virtual prices as the prices at which consumers would willingly consume the

rations allocated ( see Neary and Roberts ( t g8o) ):

aE[II(P„ t),...] -

h

_{dE[...,~r(pr, t),U] - n}

()

Pt'. ~p - AR; ~r~ ~` - ar, ~

where AR ;a;) is the ration allocated in period t 'pfe~riod 2).

Under gradualism, consumers' intertemporal budget constraint is:

3T f Poí Y-S) -Cf óóo[p( y-1-si -c] - E (g)

while under a cold turkey approach we get:

3T-~P~`(~'-S)-Cfb~Pr,[p(y-~s~-c] - E (to)

3T is output in the T sector. The welíàre gain due to a small increase in the ratiun is proportional to the wedge benveen controlled and virtual prices:

i

Er.d~,, - ( P,.-Poi. (tt) x

For given collapse prubability p(which will be endogenised in the next section), the model is closed in each period by either a market clearing equation

for the :~'T market in case market prices prevail, or by an equation defining

virtual prices if price controls are operating and binding (equations (8)). ~~'ithout price controls, market prices follow from .1'T market eyuilibrium:

Y-S -

c~E

~E y f ~ (-S) - c-jj~ .

aP

(t2)

I.2. Aggregale S'upply Resj~onse, Hoardin; and Gradualism

Consider first the case where the inventory problem has an interior solution .S'~`, and .l - fe - o lFig. t;; van ~Nijnbergrn ( t yy t) shuws that if S~` e~iscs, it is uniyue. Difièrentiati~ic; ~,5) indicates the rclation betwren thr optimal level of hoarding .S~` and the cullapse probability p:

d.S

_{~~ll~~`-P„)}

~ yj~

cu.

_~t3)

dp ~"'

~!' - t -

"~

.

r~I~hi~ ia an appruxirnatiun bcc:.usc une slrould u.~r rlrc ccn:.inl~ cyuivalrnr uf thr .ccuud Ex.riod pricc

Tt~C)~2~ P~)LI'I'iI:,SL h;f;~)NOMY t)F PRICE RECORH I:jJ(~

A'I --- ----

---0

Ai I Low Po: H.S'

0 P I

Fiq. i. Nrt aGqrc~atr ~upply .ind ihe prnbability nf crillap~c.

If there is a collapse, anticipated capital gains will not materialise, because in that case controls remain. Theretbre, a greater likelihood of collapse implies a,;reater likelihood of no price rise between today and tomorrow, and thus reduced hoarding incentives. So as credibility declines (p increases), hoarding declines and the observed supply response Y-S increases ( HS, Hoarding Schedule, Fia. t).

If credibility is very low, a cornr.r solution may be reached where no

intertemporal speculation is profitable, S- o and ~l ~ o í the Aat segment in

Fig. t). This will clearly obtain lor the extreme case of no credibility at all (p - t). At p- t, prices are not expected to rise, there will therefore not be any hoarding and the H.S curve intersects the p - t axis at Y'~.

Compare now two stabilisation programmes, each `gradualist' : prices are

moved partially in period one but fully liberalised in period two. One programme is more gradualist tlian the other in that the initial price response is smaller ~`Low Pg' versus `High PQ'). A higher first period control price P9 increases the optimal level of first period output for given incentives to hoard

~cf (5) ). This means that the flat part of the hoarding schedule ! where hoarding

is zero and output at Y~), shifts up by the increase in Yp:

J~-dP -C;,;,~o. (14i

9

Also, higher initial prices mean lower percentage capital gains once the market is liberalised. Thus the incentive to hoard will decline:

dS

_{- (p}`Bsp~P9) ~~ c o.}

dPg Noae - ~"~ci~

Therefore .~2 1;~1, with ~1.2 defined as indicated in Fig. t:

dS

(t5)

~., - ~t-dpQ

l pest ~ Ol. ( t6)

1400 _{THE ECONOMIC JOURAAL ~NOVEMBER} there will be less first period rationing, and hence less spill over into the market for second period home goods (EyP ~ o). Thus p~ will be lower, further reducing hoarding incentives; hence the area H.here .l - o shifts even further left. Thus for given collapse probability p, bolder decontrol programmes (larger initial price increases) will lead to less hoarding, larger increases in output, and as a consequence, much less problems .vith shortages.

II. SHORTAGES AND THE PROBABILITY OF REFORM FAILURE

In most of the literature, credibility of policy reforms is exogenous. But assuming exogenous credibility clearly limits the usefulness of the analysis, since the impact of an.~ polic}- will most likely depend on whether it is going to be sustained or not. Ize and Ortiz ( t g87) and Dornbusch ( I g8g) endogenise credibilitv, linking credibility to various macroeconomic variables. The equilibria they consider have primajacie plausible features. But their reliance on an arbitrary relation between programme credibility and macro variables makes one ..~onder whether that relation itself, for all its empirical plausibility, would not be afíected b}. economic policy.

ln this paper we break new ground by drawing on recent innovations in the analysis of the impact of political considerations on economic policy. Intuition suggests a link between aggregate shortages in the earl}~ stages of the programme and the likelihood that the programme will be abandoned halfwa~~. Reform programmes can be aborted for many reasons. Government officials mav be bribed by lobbyists seeking the rents created by the price controls. A balance of payments crisis mav make it impossible to continue the exchange rate policy on w~hich many such de-contrul programmes are built. The political opposition may gather strength if the initial results are disappointing. ~'e focus on the latter argument, arguably the most relevant one for Eastern Europe.

At the beginning of period 2, before the Government can implement the second stage of its reform programme, it faces a vote which determines whether it can continue or whether the opposition takes over in period 2. p is the probability that the latter happens. The ke. questiun is, what determines ~i? The vote is de jac~o a vote for or against price controls, since the opposition will reimpose (or continue) them. Voters vote for or against dependíng on the impact of controls in period 2 on their personal welfare. Pricr rises have a negative welfare eflect proportional to the initial ration receivrd. But the} will be beneficial to the extent they raise supply, since at the margin, marginal utility of one extra unit (P~) exceeds the posted price Po:

n

EudPo--Ait}(P`-Pu) ~~t~

I~92~ POL!'1'ICAL F.(;OYOA1ti' UF PRICE REFUR~1 t~r1l continuum ofvoters, indexed by s. Deline.x - d( ~"-.Sj~dP. Voters entcr period one ~~ith a particular prior distribution on x, and observe output respon~e in period one. "Chev use that information to updnte their prior into a posterior distribution used to assess the welfàre eRècts ofcontrolled versus uncontrulled prices in period s. [n rrpdatin~ their prior, voters use Baves~ rulc. Thev are ranked in ascendins; ordcr of their prior beliefon the value of x. Equation ~ r 7 ~ vields the x at which price chan~eti have zeru wrlCare eHèct, x~:

h

a- .~f ,t

~ t 8 i

` IP~-P~)~

~~-elfare maximisin~ voters will vote ves or no depending on w~hether their posterior mean is greater or smallcr than a~.

There is simple majority voting, and voters' preferences ocer the various alternatives are single peaked. Thercfore the median voter, sm, casts the decisi~e vote.' Voters know their own estimate of a and form rational expectations about econumic a~J7rel;ates, but thev do not know e~ery other voter's estimate of x. In particular thev do not know the magnitude of ,x~ sm), the rnedian voter's estimate of the supply elasticitv. ~'oters' beliefs on thc ma~nitude of a~sn,) are summarised bv a density function f. which we assume to be the same scross voten.' Since the median voter determines the election outcome, the probabilitv that the Government will be voted out before the second part of ics decontrol programme equals the probabilin. that a(s,~) e a~:

~0 I~r~ ~XJm C a~)

-J

xam-- z

To assess how hoarding in period I affects the probabilitv of collapse of the programme of price decontrol, consider how the updating process w.ill affect

f(am). Voters do not know each other's individual preferences, but they do

know that each voter updates his prior with Bayesian updating. li pdating w~ill

shift f(am) such that f contracts towards the voter who has a prior mean equal

to the value observed in period t. But the voter with prior mean x~ is more relevant, since that is the cut-off point for the voting procedure.

The voter at a~ will shift up, down or stay ~vhere he is depending on whether

the observed supply elasticity in period t exceeds, talls short of, or equals a~. All voters whose prior mean esceeds the supply elasticitv actuallv observed in period I revise their estimate of a downward. Thus if enough hoarding takes place to make the net supply response smaller than a,., the voter with prior mean eqttal to a~ shifts to the left and more weight is concentrated in the part

off defined over (- oo, a~) . The probability of collapse therefore increases if

there is enough hoarding to cause a net supply response below a~ and uice t.ersa if the actual suppl,v response exceeds a~. Withf' the distribution function of a.,m i A votc carly in a major reform programme is likelv to tx dominated bv ~.~hether voters do or do not support the proqramme. ~~'ith such a singte issue contest, median voter models are plausible descriptions o( how voting mechanisms are likeh~ to work icL Enelow and Hinnich ~ ~q8{)j.

14os

after the shift triggered by the incorporation of new information at the end of period I, we get:

Y-Y-S

.Í~(a.,~)~ -.Í~(a.," f 0.~.) ~ ~.m - ( t -'~) ( oPa oPo -a,m

a~

~ p(Yo- Yo-S) -p~ao(Po-Po)~ -

~Í(a.m)~-.Ï(a,m)~ darm

a.w--m

a~

- y0-yo gJla.tn) ualtn

,`a~tci-tri

PI-Po

7 o if (Yo-Yo-S)~(Pp-Po) c a~

(so)

G o if _{(Yo-Yo-S)~(Po-Po) ~ a~.J}

Equation ( so) indicates a negative relation between p and net aggregate supply response (the schedule VDS, for Voters Dissatisfaction Schedule, in Fig. ~.

0

P

Fig. s. Impact of aggrcgate supply response on collapsc probabiliry.

Which way will this locus shift when a more gradual reform is implemented

(i.e. a smaller price increase (Po - Po) in period t)? Difíerentiating (so)

indicates the answer:

_J

Y'-Yo-fY-Y

S)(I-~)

aiP(Yp-Yo-S)-p~a~(Po-Po)~} -

Po-Po

'

o-aPp

-

(Po-Pa)~

[r~t~~!~ PULITI(;AL Et;U!~U~1ti' nF PRICE REFURM I.}r)`j is smaller. 'I~his implics a lar~;rr shift to the left Ídowmvard revision nf prior means! and thus a hi~hcr culLtpse probahilit}~ in the low P9 casr than in thr high P~ case ~111 this makes li,r a cuunterclockwise rotation oCthe [~DSschrcíule, tr, ['D.ti' in Fig. ~~, in rrspunse to a murc~ ,gradualist llower Pq~ dcct,ntrr,l pru~ramrnr.

III. GRADUALISM, HOARlllNG AND THE POL["rICAL ECONOMY OF PRICE REFORM

~~'ith thc twt~ building blocks (the Hoarding Schcdule HS' and the Voters Dissatisfàctiun Schedule G'D.Sj derived, w-e can e~camine the consequrnces for credibility and supply response Of a gradual price decontrol progamme.

H.S' in Fig. g indicates, for a given collapse probabilitv p, how much producers chouse to hoard. A higher collapse probabilitv leads to lower expected future prices and thus gives less uf an incentive to hoard. The H.S' locus thrrefore slopes up. But more huarding luwers thr perceived supply elasticity and therrfore strengthens the voters' assessment that the programme is failing; this in tw-n increases the probability that the Government will be voted out. Thus the political economy schedule G'DS slopes downward.

Y,-Yo-P

Fig. 3. Hoarding, cullapse probabilics and price decontroL a rational expectations equilibrium.

Rationality requires that the probability of programme collapse used in producers' hoarding decisions will indeed come out if those hoarding decisions are in fact implemented. This will be the case at E, the intersection of the Hoarding Schedule and the Voters Dissatisfaction Schedule. Thus E represents a rational expectations equilibrium for a given gradual decontrol policy that sets first period prices at Po and promises to liberalise in period s. At pB, producers hoard SE for a total ( negative} supply response Yp,E-Yo-SE. In turn, such a negative supply response leads to a private revision of the collapse probability that exactly matches pE.

The equilibrium at E has many plausible features. Output rises, as current prices increase.~ Thus the initial unemployment costs of such a decontrol will ' Sce Ortiz ; t qgo), Brasv ( t g87) and Hclpman ! t q881, on rcspectively Macico, Brazil and Israel. In each

1404 THE ECOIvOMtC JOL'R1AL ~NOVEMBER be quite small or even absent. How~ever, in spite of increased output and higher prices, net suppl}~ actually reaching the market declines as producers increase inventories, hoping for later capital gains. Therefore, shortages develop, to the point that the net observed suppl~ elasticitp is in fact negative.

This in turn generates pressure against the decontrol policy, increasíng the

probabilitv that the programme will have to be abandoned for a prolonged period of controls before the final deregulation phase is reached.

Consider the consequences of a more cautious start of the programme (a lo~,.er initial period level of the controls). A lower initial price, for given collapse probabilit~ p, results in larger capital gains once prices are liberalised. Thus for given p, hoarding will in fact increase: HS shifts down to HS' in Fig. 2. If p would not change, the new equilibrium would be at .9 in Fig. 2. Uf course more hoarding implies a more negative perceived supply elasticit}~, which in turn leads to a higher p. Thus, if the I'DS schedule itself would not shift, a new equilibrium would emerge at 9', w~ith more hoarding and higher collapse probabilitv: p,,- ~

Pe-But there is more: for given nct aggregate suppl~~ response, a lower elasticity is implied. because it is in response to a smaller price change; priors thus get revised do".nw~ards more than they would under the less gradual decontrol programme and the collapse probability incrrases í T'D.S' shifts out to T'DS'). Thus the new- eyuilibrium is at E', with an unambiguously higher probabilit}- of collapse: pF. 1 p~. ) pE. Thus a more gradual approach !o price decontro! actually

increase.s the collapse probabilily.

Huwever, although there will be an unambiguousl}~ lower output response to more gradual decontrol, the impact on net aggregate supply is less clear. Un the one hand, there is more hoarding for given p since the capital gain then iticrcases; but on the other hand there will be less hoarding brcause p increases, thus reducing the likelihood that this larger capital gain "~ill in fact materialise. But it is clear from Fig. ~ that the net supply responsr inclusive of hoarding „~i11 remain nrgative if it was so to begin ,,.ith.

The samr machinerv c~m be used to assess' culd turkr~ ~ clrconn-ol approaches (Fig. .~). L~nder a cold turkev appruach, prices are immediatrl,- and full,~

tgg~] POL[TICAL ECONOb1Y UP PRIGE REFOR~1 [~Oj liberalised. Tluts if thr. appruach is m:tintaincd, prices will be market determined in both periods. C;ndcr tlte assumptions made, the first period frce market price P~ will equal the second period price~ p~`. Thus withuut credihilitv problems, there would be no hoarding, as waitin,S Ibr tomorrow will not brin,~, higher prices to ofTset storage and interest costs.

Credibilitv problems strengthen this result. If p J o, there is a positive probability that second period prices will be lnwer than first period prices, in case controls get reimposed; this would lead to capital losses on inventories carried into period ~z. Thus with a`cold turkey' approach, there are strong

disincenliues to lioard.

Therefore, if dis-hoarding would be possihle, a cold turkey approach would lead to a mu~.h larger observed net supply response than under gradualism.

This is because in that case, if there is any credibility problem at all, goods will

in fact be pulled out of inventories, for sale today rather than tomorrow. But distioarding is not possible in our set-up, so under 'cold turkey' decontrol, the zero-inventory-build-up case ( .~ - o) will ahvays obtain. This means that the line labeled HS~~ in Fig. ~}, a horizontal line at Y~t- Y~ ~ Y9-Yo 1 0, represents the cold turkey case. Thus lhere will be no áoarding under lhe cold tiv-key

approach.

The second clear result relates to credibility ( the equilibrium ~.alue of p~. Since P' ~ Py, the G'DS schedule rotates further, clockwise and still crossing thc same zero point ( compare VDS~~ with b'DSQ in Fig. 4 1. The cold turkev equilibrium is at the intersection of VD.S~~ and HS~~, at E~,. Since there is no hoarding under a cold turkey approach, there will be a high obser~~ed supply elasticitv and thus a low probabiliry of progrnmme collapse p~, ~lower, for example, than p(o)).

For comparison of the cold turkev decontrol strategy with a gradualist approach, consider two possible configurations for the latter. If the initial distortion is so small that there would be no hoarding at all in the gradual case either ( i.e. ~l - o and net supply equals Yy~, Cr.,.,. ~ o would imply a smaller supply response per unit of price increase than obser~-ed under the CT approach.

This in turn would impl}' a larger assessed probabilitv of collapse. So even if

there is no hoarding under gradualism i mild initial distortions and ~1 - o!, gradual programmes will be less credible than cold turke~~ programmes if

Cy.},}, G o. Vloreover, since ~1 - o cases have been excluded í we onlv consider

se~~erelv dístorted cases), there will always be hoarding under gradualism. Therefore, there is more of a downward revision of~ the supply elasticitv than in the.l - o case, reinforcing the result just derived for the,~ - o case. In terms of Fig. .}, HS9 falls below the line Y~- Yo at least for its initial ses;ment, and cuts

VDS9 more to the ri,ght. But a lower observed suppl}- elasticitv implies a higher

likelihood oi~ programme collapse!

1406 THE ECONOMIC JOURNAL ~NOVEMBER iggs~

Thus cold turkey programmes will unambiguously be more credible than gradual

programmes that actually cause increasing shortages in their initial phase ( pEg ~ p(o)); and even tJgradual programmes do not cause increasing shortages ( pED ~ p(o)), cold turkey decontrol programmes will still be more credible if C}1,}. G o.

IV. CONCLUSION

Should price controls be abolished `cold turkey' or can a case be made for gradualism' Two factors complicate the issue and are at the core of this paper. Price controls often focus on commodities that are storable and can thus be used in intertemporal speculation. Second, opposition to dismantling of controls is often based on claims of low supply response, and greatly bolstered if a strong supply response fails to materialise. This is especially relevant in Eastern Europe, where experience writh markets is limited.

We shoH' the difficulties that these two factors create for gradual decontrol of prices. ~~-e endogenise the probability of a collapse of the reform programme and show- that such endogeneity in the presence of intertemporal speculation leads to a strong case against gradualism. The smaller the initial price increase, the lower the observed supph' elasticity and the greater the probability that the programme of reform w'ill be abandoned.

This implies that the policy that makes most sense from a microeconomic point of view' (decontrol immediately) is also advisable from a macroeconomic point of view'. Credibility problems, which are at the core of the transitional output losses that characterise most stabilisation programmes, will be much less under a cold turke}' approach and so will therefore transitional unemployment.

The ti4'orld Bank and CEPR

Date ojrereipt ojfnal typescript: April iggs

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No. 117 A.P. Jurg, I. Garcia Jurado and P.E.M. Borm, On modifications of the concepts of perfect and proper equilibria, OR Spektnun, vol. 14, no. 2, 199z, pp. 8S - 90. No. 118 P. Borm, H. Keiding, R.P. McLean, S. Oortwijn and S. Tijs, The compromise

value for NTU-games, Intenwtional Joumol of Game Theory, vol. 21, no. 2, 1992, pp. 17S - 189.

No. 119 M. Maschler, JA.M. Potters and S.H. Tijs, The general nucleolus and the

reduced game property, lntemational Jouma! of Game Theory, voL 21, no. 1,

1992. PP. 8S - 106.

No. 120 K. Wárneryd, Communication, correlation and symmetry in bargaining,

Economics Letrers, vol. 39, no. 3, 1992, pp. 29S - 300.

No. 121 M.R. Baye, D. Kovenock and C.G. de Vries, It takes two to tango: equilibria in

a model of sales, Gumes and Economic Behavior, vol. 4, no. 4, 1992, pp. 493

-S 10.

No. 122 M. Verbeek, Pseudo panel data, in L. Máryás and P. Sevestre (eds.), The

Econometriu of Panel Data, Dordrecht: Kluwer Academic Publishers, 1992, pp.

303 - 315.

No. 123 S. van Wijnbergen, Intertemporal speculation, shortages and the political economy of price reform, The Economic loumal, vol. 102, no. 415, 1992, pp. 1395

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